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A Quick Look on Importance of Capital Structure and Different Sources

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A Quick Look on Importance of Capital Structure and Different Sources

Capital in business is the number of assets that are required by a company to maintain steady operations. Business capital usually comes in the form of equity or debt. Some companies opt for equity where a percentage of ownership of a company is given away in exchange for financial investment. Whereas, other entities may opt for debts by availing external financial assistance in the form of business loans and credits that the company has to repay in the future.

A capital structure, on the other hand, is how a company finances its operations and growth by using different sources of funds. It is usually considered as the debt to equity ratio of a company. Here is all you need to know about what is capital in business and capital structure in business.

Cost of Capital

Cost of capital is basically the weighted average cost of various capital components associated with making an investment. It is the minimum rate of return that must be received by a company on its investment in a specific project. It attracts investors to invest in the company to increase its market value.

It is a very crucial factor in determining investment options as investors are more likely to invest in projects which have a significantly better rate of return than the cost of capital.

Sources of working capital

The sources to raise capital for business are as follows-

 

  • Debt capital

Companies can obtain debt capital from a number of different sources. These sources can be classified into two categories, private and public sources. Companies can take financial aid by availing loans provided by the government and other financial entities to support businesses.

Private sources of debt financing include taking debts from friends, family and various financial institutions. Such advances can be one of the best available options as sources of working capital for any business.

 

  • Equity capital

Equity capital can be obtained from various sources. The sources of equity financing may include equity financing from friends or family, private investors, employees, etc.

Companies can also obtain equity capital financing by private placement of stock or by public stock offerings.

 

Importance of capital structure

  • It increases the value of a company

A good capital structure helps a company to increase the market price of its shares and securities which subsequently, increases the value of the firm.

 

  • It offers better utilization of the available funds

A well-structured capital structure helps a company to evaluate its requirements and to raise funds from different sources of working capital in such a way that maximum utilization is done. It protects the company from over-spending.

 

  • It offers maximization of return

A company with a stable capital structure can gain increased profits by providing a high return to the equity shareholders. It can be achieved by the mechanism of trading equity.

 

  • It minimizes the cost of capital

The cost of capital of a company can be reduced by incorporating long-term debt capital in the capital structure. It will increase the profit of the shareholders as the debt capital is lower than the cost of equity.

 

  • It provides flexibility

A proper capital structure provides the room to increase or decrease the debt capital so that the working capital can be adjusted according to the changing conditions.

 

  • It minimizes financial risk

The financial risk of a company will increase if there is an increase in the debt component in the capital structure. An adequate capital structure can protect a company from such risks with a reasonable mix of debt and equity.

Now that you know what is capital in the business and why it is important, you should be able to determine a sound structure for your company. A sound structure and right investment of capital are very crucial to keep a business healthy.

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